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Capital Versus Performance Covenants in Debt Contracts

57 Pages Posted: 26 Jan 2011 Last revised: 3 Jun 2014

Hans Bonde Christensen

University of Chicago - Booth School of Business

Valeri V. Nikolaev

University of Chicago Booth School of Business

Date Written: September 27, 2011

Abstract

Building on contracting theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debtholder-shareholder interests. Performance covenants serve as tripwires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting-based covenants can improve contracting efficiency in two conceptually different ways.

Keywords: accounting-based covenants, private debt, financial contract design

JEL Classification: M40

Suggested Citation

Christensen, Hans Bonde and Nikolaev , Valeri V., Capital Versus Performance Covenants in Debt Contracts (September 27, 2011). Chicago Booth Research Paper No. 11-06. Available at SSRN: https://ssrn.com/abstract=1747909

Hans Bonde Christensen

University of Chicago - Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

Valeri V. Nikolaev (Contact Author)

University of Chicago Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/valeri.nikolaev/index.html

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